Balance of Payments (BoP): A record of all financial transactions made between consumers, businesses, and the government in one country with others.
Key Focus: Inflows and outflows of money into and out of a country.
For details on the current account, refer to an earlier video.
Recap of the Current Account
Components:
Trade in Goods and Services (Trade Balance)
Primary Income Balance (Investment Income)
Secondary Income (Transfers Balance)
Together, these give the total income balance.
Other Parts of the Balance of Payments
Capital Account
A very small part of the BoP.
Components:
Debt forgiveness: Recorded as a debit.
International inheritance taxes and death duties
Transfer of financial assets by migrants
Sales of tangible assets and non-produced assets (e.g., land)
Sales of non-financial assets (e.g., copyrights, patents)
Financial Account
Very important and substantial part of the BoP.
Often confused with what some exam boards call the 'capital account'.
Portfolio Investment
Buying and selling of financial assets:
Bonds (corporate and government)
Shares
Financial Market Derivatives (options and swaps)
Example: U.S. firms buying UK government bonds results in inflows (credit) recorded in the portfolio investment part of the financial account.
Foreign Direct Investment (FDI)
Investing directly in production or business in another country.
Examples:
A German firm opening a factory in the UK (credit for the UK).
UK firms moving operations abroad (debit for the UK).
Reserves
Held in Currency or Gold.
Any changes in reserves are recorded here.
Maintaining Balance in the Long Run
Current Account Deficit: Indicates the country is buying more from the rest of the world than it is selling.
Financial Account Surplus: Balances a current account deficit to maintain overall balance.
Examples: USA and China
USA: Large current account deficit; balanced by a financial account surplus (e.g., foreign direct investments by countries with current account surpluses like China).
China: Large current account surplus; balanced by a financial account deficit (e.g., investing in US government bonds, shares, etc.).
Balancing Tool
Net Errors and Omissions: Ensures the BoP sums to zero if financial and capital accounts don't cover the deficit or surplus.
Conclusion
Current Account Deficits: Can’t be sustained in the long run without balancing actions in the financial account.
Next Topic: Consequences of financing a current account deficit by borrowing.